Thursday, January 16, 2014

Strategic Real Estate in 2014

There is no clarity only confusion in the economy. The unemploy- ment rate is heralded at 6.7%, yet the percentage employed of the entire working age population is at a historic low. Fewer people are working, yet the rate of unemployment declines! The stock market has exploded to new highs, yet 75% of the gains are from P/E multiple expansion and not profit growth. Further, household income, hours worked, and the all important GDP have all declined significantly while securities march to record highs. The number of food stamp recipients has nearly doubled in the last decade with almost 50 million people on SNAP. Almost 50% of the American population receives some sort of government assistance, and student loans have risen to over one trillion dollars. These obligations, along with the new Obamacare debacle, attempting to force some families into higher premium insurance policies, do not forecast a robust economy. It is time to reexamine portfolio holdings. The possibility of a recession, possibly a severe recession is climbing; since World War II the average expansion is thought to last about 44.8 months and it has been 57 months since March of 2009!

2014 Real Estate Forecast

In past posts, the recommendation has been to raise cash by liquidating marginal properties. Should a recession begin, the length can be from 11 to 43 months with the extreme during The Great Depression. A new downturn could be the 2nd leg of the Financial Crisis, as predicted by Reinhart and Rogoff in their work This Time Is Different: Eight Centuries of Financial Folly, where the colossal excesses of the debt cycle are finally corrected. Many economists believe the recession was only interrupted by the Federal Reserve’s flooding of the marketplaces with, as former Congressman Alan Grayson reports, up to $26 trillion. This may be a very volatile time and if The Great Recession can be used as a guide, most asset classes will be dramatically affected. The central banks of the world have already used most of their ammunition to force the global economy to escape velocity, but the economies of the world are heading to stall speed. The Federal Reserve is using untested methods, with its quantitative easing of $85 billion a month in Treasury and Mortgage-Backed Securities purchases, in its attempts to raise the inflation rate to beyond 2%. The Personal Consumption Expenditures Index (PCE) is at 1.2% and declining, stubbornly resisting the Fed’s efforts. All this enormous liquidity and capital added to the financial system, and yet inflation refuses to ignite; the forces of deflation must be gargantuan! Cash flow will be a very valued item!

Should the world enter another recession, real estate investors need to focus on 2017 and beyond where an enormous buying opportunity will be presented; an opportunity of generational proportions. Surviving intact will be paramount to investors, and strategic real estate may be one of the lifeboats. Strategic real estate will provide the cash flow that is absolutely necessary to survive a difficult economic environment, as yield will become increasingly scarce. Strategic real estate needs to have low or no debt, and if encumbered, any balloon or re-finance clause needs to extend beyond the 2018 period, preferably completely fixed and amortized. Rates could trend considerably higher in the coming years and properties financed now will be perceived as having favorable terms going forward. Not only may rates be higher, but appraisals may be much lower and underwriting criteria vastly more restrictive than today. Rates are currently trending lower; another re-finance opportunity may be at hand. In a downturn, prepare for lower valuations but fairly stable cash flow. A decline of perhaps 15-20% is possible. This should eventually be mitigated by lower vacancy, lower taxes through a lower tax assessment, lower insurance costs, lower labor and material costs.

The tenant quality needs to be excellent. The tenant credit rating should be above average and care should be used in accepting tenants in economically sensitive segments. An economic slowdown will affect everyone, delinquencies will rise, revenues will shrink, and job losses will ensue. However, losses can be mitigated by observant and proactive management addressing expenses and tenant quality. Not all segments will be as badly impacted and some will even prosper. Long-term government leases with such entities as the IRS, FAA, FEMA, etc., or commercial tenants in the medical sector, the defense industry, entertainment, or food and beverage businesses etc. should be less impacted, and their employees as well. Rental homes and apartments serve a basic need and will retain much of their appeal. New construction will probably suffer a severe downturn limiting additional supply, which will lower vacancy rates. Tenant migration would probably reverse as “A” tenants migrate to “B” complexes as price points should become very important. Rental rates would probably suffer as they will follow the economy lower, but rents may not suffer the full impact if the property is well located in a strong multi-industry market, another requirement for strategic real estate. Rentals in demand areas will fare the best.

In conclusion, strategic real estate properties are well located in growth and demand areas; they are leased by strong creditworthy tenants in industries that are less likely to be affected by economics, have no or very low long term debt, and have dependable cash flow. These properties will do well in an expansionary market and perform better against their peers in a challenging market. Review holdings and adjust accordingly. There is no clarity; the economy does not have to turn down, but the odds are rising and the time to prepare is running out. The current year should be the defining year if a downturn is imminent.

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